I spend most of my time digging into Wall Street, hedge funds and private equity firms, looking for both the good and the bad. I also focus on the intersection of business and the law. I have worked at Forbes since 2000.

Is The Insider-Trading Crackdown Behind Lousy Hedge Fund Returns?

In October 2009, federal agents arrested hedge fund manager Raj Rajaratnam on charges of insider trading. The arrest sent shock waves through Wall Street and in 2011 a jury convicted the former billionaire, who is now serving an 11-year jail sentence. Rajaratnam’s friend, Rajat Gupta, formerly a director of Goldman Sachs and a general corporate big shot, will go on trial in April on federal charges that he gave Rajaratnam valuable inside information on stocks.

Rajaratnam and Gupta, who has denied wrongdoing, have been the most high-profile targets of a massive effort coming out of the U.S. Attorney’s Office in Manhattan to investigate and prosecute hedge fund traders for breaking laws related to insider trading. Since late 2009, federal prosecutors in Manhattan have charged 63 people for insider-trading violations and secured 56 guilty pleas or convictions, the Wall Street Journal recently reported.

The aggressive federal investigation into hedge fund insider trading, which has included tactics like wire taps, is one of two big stories that has dominated the hedge fund industry recently. The other big theme has been that hedge fund returns on the whole have been lousy. For the $2 trillion hedge fund industry, 2011 was just about the worst year ever.

The question is whether these two trends are related?

Last year was truly an unusually bad year for hedge funds. Many hedge funds lost money. The average hedge fund that reported its returns fell by 5.1% in 2011, according to Hedge Fund Research. Hedge funds that specialize in buying and shorting stocks performed particularly badly, tumbling by 8.3%. At the same time, the stock market, as measured by the S&P 500 index, returned 2%.

There have been other bad years for hedge funds. In 2008 hedge funds as a group also performed poorly, falling 19% on average. But 2008 was the epicenter of the financial crisis, when the stock market was down some 38.5%, its third-worst year ever. As a group, hedge funds beat the market in 2008—by a lot. Another down year for hedge funds was 2002, when the average hedge fund lost 1.45%, but 2002 was a shining moment for the hedge fund industry since stocks fell by 22%.

To be sure, there is no direct evidence that the insider-trading crackdown has played any role in diminishing hedge fund returns. The evidence is purely circumstantial and there are many other good theories bouncing around explaining what happened to hedge funds in 2011. Still, the purpose of industry-wide dragnets is not only to hold individuals accountable for breaking the law, but to deter what the government views as a common practice going forward.

It was no accident that Preet Bharara, the U.S. Attorney in Manhattan, focused on insider trading in the wake of the financial crisis. As Bharara recently acknowledged, making financial crisis cases is tricky. Bringing insider trading cases, however, is reportedly viewed by federal prosecutors like “shooting fish in the barrel.” These cases are the reason that Preet Bharara finds himself on the cover of Time Magazine this week, a rare honor for a U.S. Attorney.

Bharara has made his cases in part by focusing on expert networks, an entire industry that grew in the years after the Securities & Exchange Commission adopted Regulation Fair Disclosure because of demand from hedge funds. Clearly, hedge funds that paid top dollar to be connected to corporate insiders found the information gleaned from expert networks to be valuable—it gave them a perceived advantage. But now the practice has become potentially dangerous. It is being used less, and more carefully. One lawyer who works for hedge fund managers told the New York Times in May 2011 that “with the increased attention to it, there’s been some more selectivity in the use of these services.” In other words, in 2011 hedge funds were being deterred from using services that they had previously relied on.

Insider-trading deterrence is not just coming from the U.S. Department of Justice. Starting in January 2011, the SEC reorganized its enforcement division, adding a dedicated unit to focus on asset managers like hedge funds. In Britain, the Financial Services Authority has begun to expand its definition of insider trading and demonstrated a willingness to go after activity that had previously been seen by at least one prominent hedge fund manager as okay.

In an hour-long conference call, David Einhorn recently made a compelling case that he and his $8 billion hedge fund, Greenlight Capital, did not do anything wrong after Britain’s regulator fined them $11.2 million for using confidential information to trade. Einhorn had sold part of Greenlight’s large holding in a British pub chain in 2009 after learning on a call with management that the company was considering issuing new shares and that the CEO was not optimistic about future performance. Einhorn says that he refused to accept the company’s request to sign a confidentiality agreement prior to the call and specifically asked not to receive any such information—and as a result did not receive confidential information. But the FSA claims that Einhorn avoided losses by engaging in activity that the British regulator seems to now be actively trying to deter. For his part, Einhorn does not agree, claiming that the “strange interpretation of the facts, reinterpretation of the law,” means that it’s hard to see how the FSA’s action will deter others “from similar wrongdoing.”

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We’ll never know for sure how many stars in either field crossed the line in seeking an edge. But now that everyone is very aware of the penalties for cheating — suddenly those big, booming home runs are a lot rarer.

These same federal prosecutors must take the same course of action in congress with equal vigor. How can our congressmen and senators get away with the same activity that Rajaratnam is in the can for. Will someone please explain the difference to me? If no sentators and representatives (Nancy Pelosi comes quickly to mind) are sent to the can for the same “crime” that Rajaratnam was sent to the can for then he should be released forthwith.